Give ICE credit in swaps-clearinghouse race with CME

June 12, 2009|By David Greising

NEW YORK — A cramped, windowless room with four computer workstations on tables in the center is where bad corporate debt comes to die.

From this austere room in a gleaming Midtown Manhattan office building, a group of four women on Friday will conduct an auction to set prices for General Motors Corp. bonds that went into default as GM plunged into bankruptcy. Once the prices are set, billions of dollars worth of credit-default swaps tied to those GM bonds can be closed out by the buyers and sellers who, at this point, must surely regret they ever heard of such a thing.

The GM auction is the largest since Lehman Brothers Holdings Inc. collapsed last fall. And it is happening in the offices of Creditex, a firm that specializes in processing trades in credit derivatives.

The words "credit-default swaps" still may send shivers up the spines of anyone who remembers the role that these arcane instruments, a form of insurance for investors in corporate debt, played in the economic meltdown.

The panic of 2008 has led to the mop-up of 2009. In places such as Creditex's auction room, the race is on to provide a solution to structural problems that surfaced last fall when the financial markets broke down.

The Creditex auction room is one redoubt of the effort by IntercontinentalExchange Inc., or ICE, to beat out Chicago-based CME Group Inc. in the effort to make the global financial system safe from the disasters that can arise when the market for credit-default swaps breaks down. We saw last fall how a handful of seemingly sophisticated firms can bring the financial markets to its knees when a failure by one major firm cascades to another, then another, then another.

Clearinghouses are designed to eliminate the cascading effect because they stand between buyer and seller. They assess the credit profile of both parties and charge each based on the risk they represent to the overall marketplace. They rely on member firms -- big banks and trading houses, mainly -- to provide the capital needed to prevent systemwide damage from any individual failure in the market.

Systemwide damage is a clear threat. The Lehman collapse proved that. And Treasury Secretary Timothy Geithner has called for more effective regulation and the establishment of clearinghouses and other mechanisms that can give regulators and market players better views into systemic risk.

CME Group, working with Chicago-based hedge-fund firm Citadel Investment Group, is building a clearinghouse aimed at credit-default-swap trading. The CME effort is quickly approaching a launch date.

But the ICE effort already is off the ground. ICE Trust, the exchange's clearinghouse for credit-default-swap contracts, since early March has cleared more than $600 billion of contracts for an index of credit-default swaps. ICE plans to roll out trading in individual credit-default-swap contracts soon. At present, there are $2 billion in open positions on the ICE market at any given time, a fair indicator of the market's viability.

Sunil Hirani, a graduate of Northwestern University's Kellogg School of Management who created Creditex and sold it to ICE two weeks before Lehman collapsed, said ICE is scrambling to establish leadership in the clearing of over-the-counter derivatives before any competition develops.

"When people say we aren't moving fast enough, we say we're moving faster than anybody else in the world has moved," Hirani said.

There are legitimate questions about ICE Trust. For starters, only big financial firms with $5 billion in capital can directly participate. Critics say this rule is in deference to the major investment houses that own controlling stakes in ICE.

And Craig Donohue, CME Group's chief executive, notes that ICE's head start means little. ICE Trust is clearing only a small percentage of the total trade.

"This is very early stages," Donohue told analysts earlier this year.

Still, there's an important if ungrammatical adage in financial markets: "The firstest with the mostest always wins."

ICE is first into the market with a way to clear credit-default contracts. It's too soon to say if its offering will be the most robust. But little things. even the stuffy little auction room, can lend a market presence and level of sophistication that could give ICE the edge. After all, some 400 major market players are expected to participate in the GM auction.

CME and Citadel have talked for some time about how their OTC clearinghouse will be a market beater. They'd better get to market soon, or else they'll get beat.